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June 6, 2011

Financial Crisis in Spanish Regions Pressures Central Government

Pain in Spain spreads from Catalonia to Madrid; Moody’s warning

A major Spanish region, akin to a U.S. state, has been declared “totally bankrupt” by the incoming administration. Spokesmen for the People’s Party in the Castilla-La Mancha region accused the previous socialist government of destroying unpaid bills totaling 2 billion euros.

While Spain’s socialist government denies the charge, the new People’s Party administration in Catalonia found that Spain’s second-largest region had twice the level of debt expected before assuming office. The ensuing budget chaos has prompted Moody’s to warn investors Monday that Spain’s central government will find it “very difficult” to meet its deficit reduction target for 2011.

“It’s just not a good time to point out the potential risks that would emanate from local governments having problems in Spain,” commented Vincent Truglia (left), managing director of global economic research for Granite Springs Asset Management, and former head of Moody’s sovereign risk unit.

“It just points out how the economic downturn is affecting local governments too,” Truglia told AdvisorOne in a phone interview. While Truglia dismissed Spanish politicians’ bankruptcy rhetoric, he cautioned the real onus of Spain’s financial woes falls on everyone who owns its sovereign debt. “Governments don’t go out of business,” he said. “Investors are going to have to pay for that [eventual] haircut.”

According to Moody’s, deficits in Catalonia and other provinces reveal the central government’s inability to impose fiscal discipline. By presenting a budget whose deficit amounts to more than twice Madrid’s target, Catalonian bloat suggests Spain lacks “effective tools to enforce fiscal compliance at the regional government level.” The dire finances of Spain’s ailing regional economies casts in doubt the ability of Spain to reduce its deficit from 9.24% of GDP this year to its 2011 target of 6%.

Spain's IBEX stock index fell 1.24% on the Moody’s warning. In the U.S., where markets had more time to react to the news, the iShares MSCI Spain Index Fund (EWP), a proxy for the Spanish market, plunged 2.72%. Spanish 10-year bonds declined moderately, pushing the yield past 5.26%. Just a little over a year ago, yields on Spanish sovereign debt hovered at 4%, and hit a low of 3% in happier times five years ago.

Spain’s economy cratered after its decade-long real estate bubble popped, leaving the country with severe budgetary problems and Europe’s highest unemployment rate, currently 21%. Joblessness among young workers is estimated as high as 45%. Tens of thousands of Spanish youth have been camping out at civic squares across the country, most notably in Madrid’s Puerta del Sol plaza, for three weeks now, and the so-called “indignant citizen” protests have been spreading to other European cities.

Spain, like Greece and the other PIGS, has little recourse in its debt crisis, says Truglia. One option would be for the taxpayers of the eurozone’s stable economies to transfer their wealth to pay off PIGS debt; Truglia cites the electoral success of Finland’s populist True Finns and similar parties in the Netherlands, Germany and France that are demanding a reduction in foreign aid as evidence that the populations of these countries will not tolerate such transfers. He adds that EU bailouts that just kick the can down the road will not work. “Fundamentally you’ve got to write-down that debt,” he says.